Prohibited Transaction Question

[J Simmons]

Suppose that a plan participant directs that all of his benefits, $120,000 in liquid assets, be invested in purchasing stock of a very small C corporation. Neither that participant nor anyone else connected with the plan has any involvement with the very small C corporation.

A few months later, very small C corporation is experiencing a cash-flow crunch, and approaches the plan participant about a loan. The plan participant makes an $80,000 loan to the very small corporation, out of personal (non-plan) funds of the plan participant. Has a prohibited transaction taken place?

Would your opinion be different if the loan was actually pre-arranged at the time that the plan participant directed that his $120,000 of benefits be invested in stock of very small C corporation?

Would your opinion be different if instead of a cash flow crunch, very small C corporation was doing well but wanted the $80,000 to fund a small expansion?

By way of background, my research shows that if the $80,000 loan was made at the time of or before the $120,000 stock purchase by the plan (at the participant's direction), such would likely be a prohibited transaction, because the plan assets would likely then be being used to enhance the non-plan investment (increase the likelihood that the very small corporation would be successful and be able to pay back the $80,000 loan to the participant personally). Prohibited transaction rules are to deter, among other things, fiduciaries exercising authority, responsibility or control over plan assets when they have interests that may conflict with those of the plan (Treas. Reg. § 54.4975-6(a)(5)(i)) and for the directing participant to be treated as a fiduciary for prohibited transaction purposes, see Flahertys Arden Bowl Inc v Commissioner, 115 TC 269, 115 TC No. 19 (9/25/2000). As for the fact that the very small C corporation gets the $120,000 from the plan's stock purchase, and not the participant himself, not preventing the possibility of a prohibited transaction, see Rollins v Commissioner, TC Memo 2005-260 (11/15/2004) and H. Conf. Rept. 93-1280 (1974) at 308, 1974-3 C.B. 415, 469.

My scenario does not however include the plan funds being used at the time or after the participant has already made an investment with his non-plan money. My scenario has the use of plan funds being before, and possibly unrelated, to the later loan of non-plan money to very small C corporation.

[jpod]

I agree with the technical point that a separate transaction after the plan has made the investment should not be a pt. However, the fact that this "unrelated" corporation now comes begging to this particular shareholder for a loan gives off a whiff of a self-dealing or 406(a)(1)(D) pt with the plan's investment in the first place.

[Guest Sieve]

Not so sure that the timing issue is a "technical" point, jpod. Don't see how plan assets are being used for the benefit of a fiduciary unless the plan assets are being used simultaneously with the other transaction, or later in time, but not earlier.

John - - On what basis is the participant a fiduciary with respect to the Plan? Doesn't ERISA Section 404©(1)(A)(i) preclude the participant from being a fiduciary, and therefore there can be no PT as to the participant? There could be a PT, I guess, with respect to the fiduciary who permitted the transactions to occur (e.g., the Trustee who carried out the direction of the participant) under ERISA Section 406(a)(1), since ERISA Section 404©(1)(A)(ii) does not prevent another fiduciary from being subject to liability for a PT undertaken by a participant--but I don't see how a later personal loan could even become a PT as to the Trustee or other fiduciary (who has no control over the loan).

In any event, I don't think there's a PT in the first or last scenario you pose. Plan assets are not being used for anyone's benefit, at that point, as it relates to the subsequent loan transaction (no matter what the loan proceeds will be used for). Although this may represent a conflict in interest as to the participant (i.e., the plan is a shareholder, but the individual is a creditor, and those interests can be at odds), I don't see a PT because the participant is not a fiduciary and the participant (personally) is the one who made the loan--and, no plan assets are being used in the conflict (as per ERISA Section 406(b)(2)).

In the 2nd scenario, there may be a PT because the purchase of stock was made with the understanding that a loan would be given thereafter, so the purchase of stock was a way of using plan assets for the expected benefit of the individual. Again, however, the Participant is not a fiduciary, and the Trustee would have no way of knowing that a PT had occurred--even under the prudent expert rule--so, in the end, I don't see an actionable PT even there.

[jpod]

Ok, maybe I didn't need to caveat my response by saying "technical." I was merely trying to suggest that the mere fact that the corporation is seeking a loan from the participant calls into question the first transaction, on many different levels. And, I think it's naive not to assume that there was a fiduciary involved in approving the first transaction. How many self-directed plans have you seen that would permit a rank-and-file employee to buy stock in a non-public company?

[Guest Sieve]

jpod -- Didn't mean to offend--sorry. Certainly, your point is well-taken that there is likely some pre-existing tie-in between the purchase of stock & the eventual loan--the request for the loan may have preceeded the purchase of stock, and the purchase of stock may have been to help with the repayment of the eventual loan. As to self-direction, there are lots of plans (or, at least some plans) which allow it--and, usually, the Trustee does not look behind the transaction or perform any due diligence whatsoever. Not sure, as I stated later in my post, that there would be a PT as to the participant, in any event, even if there was an arrangement which would be a PT if performed by a trustee.

[QDROphile]

The (non)fiduciary status of a participant under ERISA does not take care of concerns under the prohibited transaction rules of the tax code. A participant is a fiduciary if the participant controls the investment of a plan asset. That difference does not cause me to reach a different conclusion in every scenario, but I think the package deal is prohibited under section 4975.

[J Simmons]

The (non)fiduciary status of a participant under ERISA does not take care of concerns under the prohibited transaction rules of the tax code. A participant is a fiduciary if the participant controls the investment of a plan asset.

That is the exact distinction drawn and holding of the U.S. Tax Court in Flahertys Arden Bowl Inc v Commissioner, 115 T.C. No. 19 (9/25/2000), aff'd 271 F.3d 763 (8th Circuit) (per curiam).

EDIT: Fix a typo.

[J Simmons]

The (non)fiduciary status of a participant under ERISA does not take care of concerns under the prohibited transaction rules of the tax code. A participant is a fiduciary if the participant controls the investment of a plan asset. That difference does not cause me to reach a different conclusion in every scenario, but I think the package deal is prohibited under section 4975.

Just to make sure I'm understanding what you refer to by the package deal, if the circumstances would show that the use of the $120,000 of plan funds to purchase the stock of very small C corporation at a time when the future $80,000 loan of personal funds by the participant is either pre-arranged or contemplated, then you'd see the use of the $120,000 of plan funds to purchase the stock as a PT. But if the circumstances suggest that the loan was something that was not contemplated at the time of the stock purchase, then the fact of the later loan would not of itself render the otherwise non-PT stock purchase to be a PT. Is that what you are saying?

[QDROphile]

Yes. Once the plan transaction (stock purchase) is completed, an independent subsequent personal investment should not cause either transaction to be prohibited. I think it is too much of a stretch to say that the second transaction is self-dealing with respect to plan assets. If one wanted to stretch, the subsequent loan has certain attributes of a disguised contribution, but that is not a PT question.

[Guest Sieve]

So, John, the case you cite indicates that the language from ERISA Section 404©(1)(A)--"such participant . . . shall not be deemed to be a fiduciary by reason of such exercise [of control over assets in his account]"--does not mean what it says? I don't understand, since a fiduciary is only a fiduciry "to the extent" that there are fiduciary duties undertaken, how else this individual would be a fiduciary if not due to the individual direction of investments--assuming, of course, that the Plan fully meets 404©--unless, of course, the argument is that someone is a fiduciary to the extent that a prohibited transaction results, even if that comes in a 404© plan.

Oh well, PTs always are a bugaboo for me . . .

[QDROphile]

The cited case says the the tax code is independent of ERISA and it means what it says. There is no parallel provision in the tax code that says participants are not fiduciaries and even the ERISA section 404 regulations warn that the protections of the regulation do not insulate from consequences under the tax code.

[Guest Sieve]

OK. Makes sense. (Pretty obvious, actually . . . except it escaped me in a brain-freeze moment.)